Moving beyond a naive definition of value investing
March 25, 2020
Stock picking with the right process and the right temperament works. And, contrary to popular claims, value investing is not dead.
Those who claim it is dead, substantiate this by providing evidence that picking cheap stocks, meaning stocks with low price-to-earnings or price-to-book ratios, has been ineffective since the onset of the great recession.
What is going on? Is value investing dead or not? It all depends on how one defines value and growth investing. Investors widely use the terms value stocks and growth stocks, but many do not know what they mean. Academic researchers sort stocks by price-to-earnings, price-to-book or other valuation metrics from low to high and form a number of portfolios from the sorted stocks. They call the lowest price-to-earnings stocks ‘value stocks’ and the highest price-to-earnings stocks ‘growth stocks.’ While academics do not know which stocks from the value group value investors will eventually buy, they do know that value investors mostly choose stocks from the low price-to-earnings group, the so-called value stocks, and avoid stocks from the high price-to-earnings group, the so-called growth stocks. This is what I call the naive value investing approach.
But let’s look more closely at this naive definition of value investing and examine the reasons why low price-to-earnings and price-to-book stocks have not performed very well in recent years. Both of these ratios are a function of interest rates. As rates currently converge towards zero, these ratios of all stocks rise significantly above historical levels. In this setting, companies with very low price-to-earnings and price-to-book ratios tend to be bad companies and investing in them by definition leads to underperformance. My research has demonstrated this clearly.
At the same time, these ratios are also a function of the growth rate of earnings going forward. This relationship can be found in a mathematical formula derived from the equity valuation model taught at universities around the globe. Companies have low or high multiples because markets expect low or high earnings growth. However, the way growth comes into the mathematical formula implies that high multiple firms are expected to sustain high growth forever; vice versa for low multiple firms. The markets tend to be over-optimistic about growth for high multiple firms and over-pessimistic about growth for low multiple firms. Moreover, growth stocks’ optimistic growth rate assumption interacts with current record-low interest rates. Such interaction benefits growth stocks the most, as their future growth opportunities look very high in present value terms. As a result, particularly in the current interest rate environment, investors tend to overvalue, and overpay for, high multiple firms and undervalue low multiple firms. Hence, the growth stocks’, namely the high price-to-earnings stocks’, higher returns.
Which leads to an interesting conjecture: What if we are, for the foreseeable future, in a low inflation, low interest-rate environment? What does this mean for an investing strategy that naively considers only low price-to-earnings or price-to-book stocks? The news on this front is not good. And it is supported by historical evidence, too. Since 1966, naive value investing has had two long periods of underperformance, 1967 to 1974 and 2012 to 2019. This underperformance coincided with periods of markedly low inflation and interest rates and supports the argument that the real culprit and the common denominator for such underperformance may have been low inflation and by extension low interest rates. Indeed, the correlation between a measure of expected inflation and the value premium is 50 per cent, which quite high for such data.
But even if this is the case, it tells us nothing about the performance of value investors as fortunately, this is not what true value investors do. The process they follow goes beyond naively investing in low price-to-book or price-to-earnings stocks. Sorting by these ratios (or other metrics) is only the first step in the value investing process. Next, they value each of the lowest price-to-earnings stocks to find their intrinsic value. Finally, they compare the intrinsic value of each stock to the market price. If the stock price is less than the intrinsic value by at least the so-called “margin of safety” (normally around 33 per cent of the intrinsic value), the stock is considered to be truly undervalued and is worth investing in. Most people believe that the only thing that value investors do is sort stocks by price-to-earnings and invest in the lowest price-to-earnings stocks. This cannot be furthest from the truth. True value investors follow with discipline and patience the three-step process referred to above.
On a more optimistic note, however, there is some evidence to indicate that naive value investing seems to shine after a long period of underperformance. For example, the bleak years between 1967 and 1974 were followed by a long stretch, with small interruptions, of outperformance of a low price-to-earnings or price-to-book strategy between 1974 and 2011. If this is the case, and given the 2012-2019 period of underperformance of naive value investing, this means we may be at the threshold of a golden period for value investing once more.